Escrow: What it is and how it works

January 8, 2021 - 7 min read

What is escrow for a mortgage?

By definition, ‘escrow’ means placing something of value in the care of a neutral third party until certain conditions are met.

In the mortgage process, an escrow company holds onto the cash involved — like your earnest money deposit —until the transaction has been finalized.

Escrow makes real estate transactions safer and smoother.

  • When buyers put up a good faith or earnest money deposit, the escrow company holds the money until the sale closes
  • The escrow company combines down payment funds and loan money to pay the home seller
  • If the seller still has a mortgage on the property, the escrow company pays it off with proceeds from the home sale
  • Escrow officers also disburse other expenses like real estate commissions, lender fees, property taxes, and homeowners insurance

Escrow agreements make real estate transactions safer. For example, it’s a lot easier to get your good faith money back from an escrow company than from a seller who’s already spent it.

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How does escrow work?

When you buy a house, an escrow company will be involved in the mortgage process from the time you make an offer through to closing day.

Your real estate agent and loan officer will be there to help you through this process, so don’t worry if the concept of escrow is a little confusing.

But it’s still a good idea to have a basic understanding of how escrow works to facilitate real estate transactions.

  1. Buyer and seller agree on a purchase price
  2. Buyer provides an earnest money deposit held by the escrow officer
  3. The escrow officer works with the seller and agents to clear any title problems
  4. Both parties agree on a home inspection, ordered by the escrow officer
  5. The escrow officer provides the lender with a title commitment
  6. The escrow officer reviews the initial closing disclosure. He or she then issues the final disclosure
  7. The escrow officer closes the transaction

Here’s how escrow works at each stage in a little more detail.

Opening escrow: Money enters the account

In many cases, an escrow officer or attorney holds the earnest money you’ll pay when you sign a contract to buy a home.

Your earnest money — which can also be called ‘good faith money’ — tells everyone you’re serious about purchasing the home. Assuming your home buying process moves forward as planned, this earnest money will later be applied toward your down payment.

But if you don’t buy the home — because of a problem the home inspector found, for example — you can usually get your earnest money back.

Because this money sits in your escrow account, you can get it back easily, as long as you are backing out of the purchase for a reason covered in the purchase contract.

The closing: Money leaves the account

On closing day, you’ll bring funds — typically a wire transfer or cashier’s check — to cover the closing costs and down payment (minus your earnest money).

This money goes into escrow along with the rest of your purchase price, provided by the mortgage lender. The escrow company will combine the down payment and loan money to pay the home seller.

The escrow officer also pays out other funds as instructed — including commissions to the real estate agents, origination fees due to the lender, and fees to third-party providers like inspectors and appraisers.

Sometimes, money can remain in escrow after closing to pay for repairs the seller and buyer agreed on before closing.

You’ll probably also sign your final documents on your closing day. However, it’s better if you can get a copy of these documents in advance and go through them with more time and less pressure.

Home buyers feel overwhelmed at the closing table, so don’t hesitate to ask questions about escrow payments and other documents.

Ongoing escrow, aka “impounds”

After closing on the home, you’ll most likely encounter yet another escrow account. Your mortgage servicer manages this one, and it’s designed to help you pay property tax and insurance bills.

Each of your monthly mortgage payments will include four parts: loan principal, mortgage interest, property taxes, and homeowners insurance (often referred to as ‘PITI’).

Most homeowners pay all four parts at once, into an escrow account. Then the escrow company distributes the funds as needed: loan principal and interest to your mortgage company, taxes to your local tax authority, and homeowners insurance premiums to your insurer.

The funds in your ongoing escrow account may also be referred to as ‘impounds.’

This is the most common way to pay homeowners insurance and property taxes.

But note, impounds will increase your closing costs, as the escrow company often frontloads the first 6 months or more of insurance and property tax bills.

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Other escrow duties

Escrow officers don’t just oversee funds and paperwork. Francis Betancourt-Molina with Florida Capital Bank says they can serve other crucial functions, too.

“They can order services agreed upon by the parties,” she says. “These include ordering home inspections, surveys, title search, and title commitment. They work to clear any title exceptions on the property.”

Escrow officers have plenty of closing duties, as well.

“They walk the parties through the signing of the loan closing documents. They send the mortgage instruments to the county clerk for recording. And they send the closed loan package to the lender,” she adds.

Also, “They make sure that prior loans are paid off. They check that taxes due have been paid, and that current tax years have been prorated,” says Bruce Ailion, Realtor and real estate attorney.

Escrow requirements

Every home purchase usually requires the first type of escrow: the holding and disbursement of earnest money by a third party.

“When you make a deposit, it’s almost always required that a third-party escrow officer hold those funds in escrow. But it doesn’t have to be an escrow company,” says Ralph DiBugnara with Residential Home Funding. Instead, it can be an attorney, closing agent, or title company.

The seller or seller’s agent likes to pick the escrow officer/company.

“But the buyer doesn’t have to agree. The parties can negotiate who to use,” says Betancourt-Molina. “On mortgage refis, the borrower picks the escrow agent. In this case, the lender can provide a list of suggested companies to the buyer.”

RESPA — the Real Estate Settlement Procedures Act — lets the seller choose a title company if the seller pays for both the owner’s and lender’s title insurance policies.

But the seller or seller’s agent cannot legally make the buyer pay for both the owner’s and the lender’s title insurance policies and also insist on choosing the provider.

Many states also require the second type of escrow: closing using an escrow process.

“This helps satisfy the lender,” Betancourt-Molina says. “They need to confirm that there are no unacceptable title impediments, survey exceptions, unpaid taxes, or liens against the property.”

Lastly, many lenders require the third type of escrow: the holding of extra funds in an escrow account to pay taxes and insurance. They may handle this process themselves or hire a loan servicing company to do it for them. Every year, lenders examine the escrow account and adjust it if necessary.

How much do escrow services cost?

DiBugnara says fees for escrow services can vary.

“Thankfully, the borrower is not charged when their deposit is held and paid out by the escrow officer,” he says.

Other services come with a price. These include duties like ordering surveys, handling title matters, and assisting in closing.

“The escrow company determines these costs. But the charges must be customary and reasonable for the area,” Betancourt-Molina says.

“In my state of Georgia, the attorney fee could be $500 to $1,000. Title search can cost $250 if the title is clean. A tax search costs about $50. And title insurance fees vary based on the price of the property,” says Ailion.

Per the National Association of Realtors, escrow costs add 1 to 2% of the cost of the home. Often, the buyer and seller split the charges, depending on local custom. Of course, everything is negotiable, and when you refinance, those costs are all yours.

Is escrow a good thing?

During the home buying process, escrow helps protect both the buyer and seller. That’s because a neutral third party handles the money and holds funds securely.

An escrow agreement is ultimately a bank account that neither the seller nor the buyer controls. This has a variety of advantages.

For example, the independent escrow officer disburses money on time to the lender, agents, taxing bodies and other parties. This prevents disputes. Plus, it makes matters much easier for buyers and sellers.

Ongoing escrow accounts

Ongoing escrow accounts that pay annual tax and insurance bills are not always the first choice of homeowners who prefer to control their own expenses. But you might not have a choice in the matter.

Government-backed mortgages such as FHA or USDA loans require an escrow account for taxes and insurance.

Borrowers with conventional loans may be allowed to skip the escrow account and manage taxes and insurance themselves if they make a 20% down payment. But if you choose this option, you can expect a higher interest rate — often around 0.125% above the rate you’d have gotten otherwise.

Lenders charge these fees because they prefer setting up escrow agreements for borrowers. Why? Because escrows or ‘impounds’ help ensure the homeowners’ on-time payments for insurance and property taxes.

Lenders would lose money if a homeowner failed to pay their tax bill and the local government seized the property. Lenders could also lose money if the borrower didn’t pay the insurance bill and had no coverage when a fire or storm destroyed the home.

Escrow benefits

Most homeowners find ongoing escrow accounts convenient because they remove the need to come up with large lump sums for taxes and insurance bills each year.

Plus, escrow lets you mortgage lender manage your payment amounts.

If the county lowers property taxes, your lender will lower your monthly mortgage payments to prevent overages. Likewise, if your insurance premiums or tax costs increase, your lender will compensate by increasing your monthly mortgage payment.

Remember that there are laws around escrow accounts – mortgage servicers can’t just collect escrow money or hold unfounded sums indefinitely. They must reconcile escrow accounts each year to make sure they are collecting and holding enough funds but not too much.

Lenders and servicers handle the details of these funds, but as a homeowner and a home buyer, you should ask questions about anything you’re not clear about. Learn about the costs involved. And choose an escrow professional you can trust.

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Erik J. Martin
Authored By: Erik J. Martin
The Mortgage Reports contributor
Erik J. Martin has written on real estate, business, tech and other topics for Reader's Digest, AARP The Magazine, and The Chicago Tribune.